Targeting Public-Sector Unions

Manhattan Institute scholar Fred Siegel has spent much of his career studying the decline of American cities. What he sees in New York now is,...

Manhattan Institute scholar Fred Siegel has spent much of his career studying the decline of American cities. What he sees in New York now is, he says, "Madison's nightmare, government by a single faction." That faction, in Siegel's opinion, is the state's public-sector unions.

"Legislative government in New York is broken down," says Siegel bluntly. He marvels at the way in which union representatives openly huddled with legislative leaders to kill a plan to expand charter schools in the last legislative session. "The Legislature has come to be understood as an extension of the public-sector unions on anything that matters to it." The result of this virtual takeover, he says, has been a surge in unsustainable spending - and not just in New York.

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"Illinois is insolvent, New Jersey is virtually insolvent, and we all know about California," Siegel says. "This is not a local problem. The question of the power of public-sector unions is not going to go away."

Siegel isn't an isolated critic. Barry Bluestone, the dean of Northeastern University's public policy school, grew up in a union family. His father was the right-hand man of legendary United Auto Workers (UAW) leader Walter Reuther, and Bluestone worked summers on a UAW assembly line. Yet he worries about the impression that unions today exist only to benefit their members.

"I think that change from solidarity with everyone to just solidarity with their own members is leading to a precarious position for public employee unions in many states throughout the country," says Bluestone.

State and local government officials who once deferred to politically powerful unions are increasingly taking note - and taking aim at traditional union benefits. Last summer, Illinois Gov. Pat Quinn threatened the state's largest public-sector union with the prospect of 2,600 layoffs unless it acceded to new demands for cost savings. In New Jersey, newly elected Gov. Chris Christie has come out swinging, with blistering attacks on the state's dominant teacher union. Moral outrage has played an important role in this process. Boston-area newspapers reveled in the story of a firefighter who, just weeks after being declared "totally and permanently disabled," placed eighth in a men's bodybuilding contest. Californians have been treated to lists of California Public Employees' Retirement System "$100,000 Club," a group that, according to investigative journalist Ed Mendel, includes 6,133 people.

With both fiscal necessity and moral indignation filling their sails, conservatives have seized the moment to argue that radical changes in state and local governments' relationships with public-sector unions are overdue. A recent article in The Economist captured the emerging conventional wisdom: "Public-sector workers are spoiled rotten," wrote the anonymous correspondent, citing their overly generous wages and excessively generous compensation packages. The prescription was straightforward: Cut wages and benefits, and most importantly, move away from generous "defined benefit" pension plans and toward "defined contribution" plans that now dominate the private sector.

Not surprisingly, unions strongly disagree with such critiques. "Our members are certainly not coddled," says Kerry Korpi, director of the Research and Collective Bargaining Department for the American Federation of State, County and Municipal Employees (AFSCME), the country's largest public-sector union. Korpi makes no apologies for the fact that most AFSCME members who spend their careers working for state and local governments have health insurance and a pension - typically in the low $20,000 per year range. "If that's the definition of 'spoiled rotten' in our culture, then more people ought to be spoiled rotten."

Certain facts are indisputable. Unionized workers now account for 40 percent of state and local government's work force - as opposed to a mere 7.2 percent of the private-sector work force. As a result, cutting personnel costs at the state and local government levels means taking on unions. That doesn't mean it's time for the public sector to follow the lead of the private sector. In fact, the prescriptions being peddled to public-sector leaders would come with some dangerous side effects.

The first item on the brief against public-sector unions is that they're overpaid. According to the U.S. Bureau of Labor Statistics, public-sector employees earn $908 a week on average - 22 percent more than their private-sector counterparts, who bring in a mere $710 a week. As a result, some union critics believe there are opportunities for governments to squeeze the wages of unionized workers.

But such straightforward comparisons are misleading. "Part of the problem is you have to compare like with like," notes Trinity University labor economist David Macpherson. Public-sector workers, says Macpherson, "tend to be more educated than private-sector workers." Most are teachers, a group for whom it is difficult to construct an appropriate comparison group. (While there are, of course, private-school teachers, their numbers are small, and working conditions don't often match up.) When economists take education and other variables such as location into account, the pay discrepancy largely vanishes, at least for state and local government employees. Low-skilled workers may earn more than their private-sector counterparts, but high-skilled public-sector employees probably earn less.

Of course, wages make up only part of an employee's total compensation. Benefits are also important, and the benefits of many public-sector unions are famously generous. That's because when unions first started to organize the public work force nearly four decades ago, many chose to avoid the more visible and controversial issue of wages in favor of the promise of more generous treatment in the future. As a result of this strategy, most public-sector workers - 84 percent - still enjoy traditional, defined benefit pensions that, after their retirement, pay them a fixed amount every month. In comparison, 81 percent of private-sector employees now rely on defined contribution plans such as 401(k)s, where workers save a portion of their earnings (which may or may not be matched by their employers) and then upon retiring, receive a lump sum payment.

From an employer's perspective, defined contribution plans have real advantages over defined benefit plans. They move the investment risk - the possibility that investment returns may fall short of expectations - from the employer to the employee. There are benefits for employees too. 401(k)s are portable. Savings can easily be taken to another job. In contrast, most defined benefit plans reward employees for their longevity: Benefits typically accrue at a higher rate after a decade of service. Yet despite these advantages, only a handful of states - Michigan, Alaska and Georgia among them - have moved toward creating defined contribution plans for new employees.

Is this an oversight that budget cutters should now address? The answer is less obvious than it appears. Consider the case of Michigan.

In 1997, Michigan became the first big state to switch all new state employees to a defined contribution plan. Previously state employees contributed nothing to their pension plans while the state took responsibility for delivering a stream of benefits (based on employees' earnings) for the remainder of that employee's life. Post-reform, the state agreed to contribute 4 percent of employees' wages to each employee's plan and to match employee donations up to another 3 percent. The state incurred some additional up-front costs (the 4 to 7 percent contributions) but obtained a very significant benefit as well: It was no longer responsible for supporting state workers after they retired.

From a purely bottom-line perspective, this was probably a good deal for state taxpayers. But switching from a defined benefit plan to a defined contribution plan doesn't always pay off. Lawmakers recently asked the House Fiscal Agency, Michigan's nonpartisan legislative analysis office, to consider the impact of shifting the state's 465,000 teachers and retired teachers (and spouses) into a defined contribution plan. Unlike state employees, Michigan teachers have long contributed a significant portion of their salaries (between 5 and 7 percent) to their pension plan. State analysts noted that diverting contributions from new teachers to a different plan would open up a funding shortfall that the state would have to fill-a shortfall that would amount to roughly $250 million in the first year alone. Not until 15 to 20 years from now would the state see any savings. The conclusion, says Mitch Bean, the director of the Michigan House Fiscal Agency, is clear: "It really depends on contribution to see if [a switchover] makes sense."

There's another consideration too, says Phil Stoddard, who runs the Michigan Office of Retirement Services, which covers state employees and the Public School Employees Retirement System: the impact of pension reform on the state's communities as a whole.

When the Michigan retirement system switched over to a defined contribution plan 13 years ago, it made a major effort to educate employees about how much they needed to enjoy a secure retirement. Despite these efforts, Stoddard says that most of the 24,000 state employees enrolled in the defined contribution plan aren't saving nearly enough. While the state diverts 4 percent of employee salaries into retirement accounts, 30 percent of state employees are not contributing to the defined contribution plan at all, thus forgoing a generous "match" from the state and a great opportunity to substantially bolster their retirement accounts.

"That's the biggest problem," Stoddard says, "the problem of adequacy." He worries that while the state may have succeeded in capping its costs, it may be replacing current retirees who, thanks to the defined benefits plan, are secure in their retirements and able to sustain their local communities with a new generation of retirees with inadequate savings that are at the mercy of the market.

"There is going to have to be more of a commitment from employees who will benefit," says Stoddard, but "on the practical side, it's difficult for me to see how we're not creating a new set of problems."

Some states have attempted to address the problem of uncapped liabilities on the one hand and insufficient savings on the other with a so-called hybrid pension. The most recent state to move in this direction was Georgia.

Georgia's motivation wasn't cost cutting, says Sen. Bill Heath, who chairs the Senate Retirement Committee. It was competing with the private sector. According to a state study, public-sector salaries amounted to only 84 percent of the salaries of their private-sector counterparts. The state's generous benefits package made overall compensation comparable, but many younger employees simply didn't value the state's generous pension plan. So two years ago, Heath spearheaded an effort to create a hybrid pension plan for new retirees. It offers a defined benefit "core" that is only half as generous as the previous defined benefit plan. However, it compensates for that by adding a defined contribution component whereby the state matches employees, first 1 percent contribution dollar-for-dollar and then provides a half-match to contributions from the 1 to 4 percent.

So far, the take up has been slow (largely because Georgia has a hiring freeze). However, Heath hopes the new hybrid will eventually attract new employees. Health also hopes the hybrid plan will address one of the biggest problems with current defined benefit plans-state legislatures.

"The problem with defined benefits plans is not the defined benefit-that's great," Heath says. "The problem with defined benefit plans is that you can't keep legislatures' hands off of them." When the economy booms, legislators are tempted to buy union support with enhanced benefits and reduced contributions. When the crash comes, many plans are underfunded. By vesting assets with employees, Heath hopes his plan will remove the temptation that too many defined benefit plans have, while also giving younger employees what they want. In that, he may succeed. What seems less likely is that such plans will provide the necessary funds for retirement. Only 6 percent of the enrollees in Georgia's new hybrid plan are participating at the maximum matching rate of 5 percent. Those 6 percent will probably do better under the new system than they would have under the old. Everyone else probably won't.

Changing public pension arrangements is difficult. Many enjoy statutory, constitutional and collective bargaining protections. Most are fiercely guarded by public-sector unions. Given the analysis presented here, it would be easy to conclude that it's not worth the trouble. In fact, some states have done just that. Take New York. Albany faces a probable deficit of $9 billion this year. When the final federal stimulus dollars are spent, that number could swell to $19 billion the following year. Yet Gov. David Paterson's recent budget proposal proposed a 0.9 percent spending increase and virtually no layoffs for this year.

Such non-responses are simply not sustainable. State and local governments with underfunded pension plans are going to have to find a way to scale back benefits and increase employees' contributions. Government officials also need to get a much better handle on retiree health benefits. During the boom years of the 1990s, many state and local governments significantly expanded retiree health benefits such that the number of Medicare-eligible employees receiving retiree health benefits rose from 69 percent in 1997 to 86 percent by 2002. Not surprisingly, costs rose too. In California, for instance, health and dental benefits more than tripled between 1988 and 1999 and 2006 and 2007, rising at five times the rate of overall state spending. According to the General Accounting Office, the price tag for retiree health now exceeds $530 billion - and that's just states and three dozen-odd cities. There are no numbers on what the retiree health benefits of this country's cities and towns might be.

Yet so far, most states have made only modest efforts to contain these costs, typically by creating things like disease management and wellness programs. Most cities, counties and school districts have done nothing to rein in retirement health benefits at all. The result is a looming chasm of unfunded liabilities.

For states such as New Jersey and Connecticut, curtailing public-sector benefits will be very important - and no doubt very challenging.